Commodity investing is a useful skill for any investor to know. Commodities can provide opportunities for both diversification and profit, but also come with significant risk. Before investing, it is very important to understand both the basics of commodities markets and the key risks involved.

Steps

Part 1

Understanding Commodity Investing

1

Familiarize yourself with the concept of commodities. A commodity is simply a good that is interchangeable with other commodities of the same type, and that is usually produced and sold by many different companies. For example, a barrel of oil of one particular type, such as Brent crude, is the same product regardless of who makes it.[1]

This is opposed to a consumer product like a computer or automobile, for example. These products differ dramatically between producers and cannot be easily exchanged for one another.

Note that while the quality and characteristics may vary somewhat between types of a particular commodity (for example, Brent crude oil is typically higher quality than West Texas Intermediate crude), producers would be generally willing to exchange products of the same type with one another.

There are many different types of commodities. They include, but aren't limited to: gold, oil, natural gas, coal, copper, zinc, potash, nitrogen, phosphate, live cattle, hogs, orange juice, cotton, sugar, and even coffee.

2

Learn the reasons for buying commodities. Commodities offer an opportunity for both diversification and profit. Commodities are an asset class, like stocks, bonds, cash equivalents, or real estate. Each asset class has different properties, and owning commodities can be a useful way to diversify your portfolio.

Commodities don't always move in the same directions as other asset classes. For example, when the stock market falls 30%, it is possible that a commodity like gold could stay flat, or even rise. The fact that commodities are not strongly correlated to other asset classes makes them a great way to diversify your portfolio.

Commodities are also a useful way to protect against inflation. Inflation essentially refers to the cost of goods increasing over time (due to money losing value), and as inflation increases, so do commodity prices. It is for this reason that people who are worried about inflation often buy commodities.

Commodities can also be traded to make a short-term profit. They are extremely volatile (meaning that their prices move around a lot), and as a result people looking to make a short-term profit look to capitalize on these swings. This volatility is due to the fact that commodities are heavily traded and speculated on, which leads to more movement in the prices.

Commodity investment can also be used as a method of hedging. Hedging requires taking a position in a futures contract opposite your position in the real commodity. For example, a farmer may buy wheat futures when he plants his crop to make delivery of wheat when it is harvested. As a consequence, he is protected against price changes while the wheat is in the ground.[2]

3

Understand the risks of owning commodities. Commodities as an asset class are considered high risk due to their price volatility and leverage compared to other investments. Over a very short period of time, commodities can gain, or lose dramatic amounts of value.[3]

For example, between the beginning of June and the beginning of September 2015, the price of crude oil lost 26%. At the start of September 2015, crude oil then shot up 4.5% in one day.

It is because of this risk that commodity investing or trading is typically for more sophisticated investors.

One popular way in which commodities are purchased is through what is called a futures contract, and futures investing involves a high amount of leverage (which basically means that the majority of the investment is made with borrowed money). Essentially, using leverage on a futures contracts magnifies your potential gains or losses and therefore is even riskier than non-leveraged commodity investments.[4]

Part 2

Buying Commodities Through ETFs or Mutual Funds

1

Learn the definition of Mutual Funds and ETFs. An ETF stands for an exchange-traded fund, and these, along with mutual funds, are both "baskets" of investments. When you buy a mutual fund or ETF you are purchasing a collection of different types of investments, which could include commodity stocks, non-commodity stocks, bonds, or direct commodities.[5].

With a mutual fund, the basket of investments is managed by a professional investor who actively monitors and changes the investments, and you purchase units in the fund. The value of your units then goes up or down depending on whether or not the basket of investments goes up or down.

An ETF is similar to a mutual fund, except many ETFs often do not have a manager actively buying and selling depending on their goals. Instead, ETFs often track something known as an index.

An index (like the Dow Jones or S&P 500 index) simply indicates how a group of investments are doing. For example, the S & P 500 index contains the prices of the largest 500 companies in the U.S. When you hear "the S & P is up 10 points", it simply means combined price of all those businesses is up $10.

There are also commodity indexes that do the exact same thing. A complete commodity index, for example, would simply indicate what the combined prices of all commodities are doing. A complete commodity ETF would simply go up and down with that index, since it owns the same commodities that the index tracks.

2

Review the risks and benefits of commodity ETFs and mutual funds before buying. The main benefit to purchasing commodities through ETFs or mutual funds is simplicity. Mutual funds and ETFs are bought and sold just like stocks, and they do not require you to own the commodity itself. [6].

ETFs and mutual funds also allow you to own one, many, or all commodities in one basket, due to the huge range of products available. For example, there are ETFs that contain all commodities, and some that just contain oil, or gold for example.

Purchasing an ETF or mutual fund that owns multiple commodities can also be much less risky than simply owning one commodity, since commodities do not all go up and down together. This is because each commodity has different supply and demand forces determining the price, which means on one day gold may be up, and potash may be down, for example.

The main risk of ETFs and mutual funds lies in the fact that at the end of the day, these funds still hold commodities, which can be volatile and risky. While owning an ETF or mutual that holds a basket of different commodities can reduce risk, the risk of losing some or most of your investment is always there.

3

Open an online trading account. The first step in buying commodity ETFs or mutual funds is to open an online trading account. There are multiple brokers available, and commonly used brokers are TD Ameritrade, Capital One Investing, E*Trade, Charles Schwab, and Tradeking.

When choosing an broker to open a trading account with, always be mindful of fees. Fees are typically charged per trade, and can range from $4.95 to $10.00. Stockbrokers.com is an excellent resource to compare brokers, and their fees.

There is a minimum balance requirement you must meet in order to trade commodities on most platforms. At some brokerage firms this can be as much as ten-thousand dollars. Check with your broker to find out how much you will need to deposit. Many brokers require a confirmation of an investor's experience before opening an account to trade commodity futures and options.

Most brokers have completely online registration that simply involve filling out information, and then funding the account with money from your bank account.

You can also download the forms, complete the information, and then mail it back to the brokerage firm.

Select a mutual fund or ETF to purchase. There are thousands of available products to accomplish this. To determine which is right for you, you need to ask yourself what your goals are. For example, do you want exposure to all commodities as a way to diversify your portfolio? or are you looking to profit from a specific commodity gaining in value?

If you are looking for broad exposure to many commodities, consider ETFs that contain a small sample of every commodity. One example would be the iShares S&P GSCI Commodity-Indexed Trust ETF or the PowerShares DB Commodity Index Tracking Fund. These funds each contain many commodities,and are good ways to gain access to the entire commodity market. [7]

If you want exposure to only one commodity, such as oil for example, etfdb.com can be a very useful resource to find complete lists of all the ETFs that give you exposure to just one commodity. Alternatively, doing a google search for the name of the commodity you want to invest in, followed by the word ETF can yield many examples of ETFs to consider.

5

Purchase your ETF or Mutual Fund. Once your brokerage account is opened, and you have selected a product you want, you can proceed to purchase. While the exact procedure varies between brokers, the basic process remains similar.

Start by opening a new order. Once an order is open, enter the ticker symbol for the investment you want to buy. Google the name of the ETF to locate the ticker symbol.

Once you enter the symbol, you will need to enter the amount of units you want to buy. To determine this, you need to know how much money you want to invest. If you want to invest $1,000, and the units are trading for $100 each, you can purchase 10 units.

At this point, click "buy", and you will own units of the ETF.

Part 3

Purchasing Commodities Through Futures Contracts

1

Learn about futures contracts. Futures contracts are the main way commodities are directly traded, and this is a highly risky and sophisticated means of owning commodities. Therefore, this is only recommended for advanced investors and traders.[8]

A futures contract refers to an agreement to to make or take delivery of a predetermined amount of a defined commodity at a specific point in the future for an agreed-upon price.

Contracts are generally in standardized units. For example, a standard contract for Brent Crude Oil is for 1000 barrels. There are also "mini" contracts available for 500 barrels.[9]

For example, you may enter into a contract to to purchase a 1000 barrels of oil at $40 per barrel on December 1st, 2015. This contract would then be worth $40,000 (1000 times 40). If the price of oil rises to $45 per barrel before December, your contract is now more valuable because it allows you to purchase the product at $40 a barrel. You could then sell the more valuable contract before the due day to earn a profit. In this case, you would sell it for $45,000 ($45 per barrel times 1000 barrels), making a $5,000 profit.

2

Realize the risks before purchasing futures contracts. Futures contracts are very risky, which is why amateur traders should not use them without extensive research.

Futures involve something called buying on margin. This means you only pay a small portion of the value of the contract, with the rest being borrowed. In the previous example, you would only pay 25% of the $40,000 value of the oil contract for example. This means if you sold it for $45,000 like in the example, you would make a 50% profit (because you would make $5,000 on an $10,000 investment).

This also means you can quickly lose 50%, or much more, if the price moves against you. If the price dropped $5 per barrel, you would lose half of your investment. Your original equity was $10,000 and you borrowed $30,000 to buy the initial contract at $40 per barrel. If you sell the contract at $35 per barrel, the proceeds would be $35,000. After paying off the loan of $30,000 plus interest, your equity would be worth less than $5,000.

Keep in mind that in some cases you may be required to put up more than 25% for investments bought on margin. This depends on your broker and the investments made.[10]

Futures also have very high commissions (relative to required investment for contract, not total value of contract), and require advanced strategies and knowledge to trade well.

3

Purchase futures contracts. If you have the knowledge, you can use futures to trade a commodity you are interested in. To do this, you will need to find a broker that offers futures trading.

Many brokers that offer ETFs and mutual funds often offer futures trading. Popular brokers include TD Ameritrade, E*Trade, and Tradestation. [11]

When you are ready, purchasing a futures contract involves a few simple steps. You will need to select the type of commodity you wish to purchase, and then you will need to select the month in which the contract expires, as well as the number of contracts you wish to purchase.

For example, you may want to purchase 3 December 2015 crude oil contracts at the available price of $38 per barrel.

Most brokers have drop down menu's with the various dates, contract amounts, and commodities available. You simply need to select the options you want, and then click buy.

Part 4

Investing in Commodities Using Futures Options

1

Learn about futures options. Futures options are another type of investment that adds another level of complexity to futures contracts. Whereas futures allows an investor to simply buy or sell a contract to make or take delivery of a commodity, options trading gives an investor an option to buy or sell a specific futures contract to make or take delivery of a identified commodity at a set price in the future. These options allow traders to respond to market changes.[12]

Specifically, a call option gives an investor the right (but not the obligation) to buy a futures contract, called the strike price. A put option gives them the right (but not the obligation) to sell a future contract.[13] The price paid for the option is the strike price and is independent of the futures contract price.

If this seems confusing, that's because it is. Many financial professional advise that individual investors, especially inexperienced ones, stay away from options investing entirely.[14]

2

Understand the risk and benefits of futures options. Futures options are primarily used for two purposes: speculation and hedging. Both come with unique sets of benefits and potential risks.

Speculation with futures options is essentially the same as speculating on any other security, with one big difference. With a normal speculative investment, you are simply betting that the price of a security will rise. With a futures option, you are projecting that the price of a commodity will rise or fall in excess of the option strike price within a specific time period. This makes this type of speculation incredibly difficult.

Unlike other investments, options have a limited life and most expire without being exercised. Investors do not own anything but a right to buy or sell for a limited period of time.

Hedging, the other use for futures options, is considerably less risky. Essentially, hedging through futures options is an insurance policy for your current investments. You could, for example, purchase a put option such that you could sell off your investment and minimize your losses in the event of an unexpected drop in that asset's price.

3

Purchase futures options. If you've decided to purchase futures options, you can likely do so with your current broker. Many online brokerages offer futures options trading. Be sure to check with your broker to be sure that you stay in line with any specific requirements for options trading.

Even though put options require that you sell a commodity contract, you don't necessarily have to own this contract to buy the option.[15] Most options — calls or puts — are not exercised by the original purchaser who simply sells the option on or before its expiration date to close out the position with a profit or loss.